The accounting nature of inventory
Inventory is an asset that is intended to be sold in the ordinary course of business. Inventory items call fall into one of the following categories:
- Held for sale in the ordinary course of business
- That is in the process of being produced for sale
- The materials or supplies intended for consumption in the production process
In accounting, inventory is typically broken down into three categories:
- Raw materials
- Finished goods
Each of the preceding inventory categories is usually given its own account in the balance sheet. If a manufacturing firm engages in production activities that cover only brief periods for each item, then there may be no work-in-progress inventory recorded in the balance sheet.
Auditing nature of inventory
There are several general characteristics of inventory that can impact the contents of the audit plan:
- Transaction frequency
- Multiple locations
- Proportion of assets
- Diversity of items
- Costing methods
- Fraud risk
- Impact of cutoff issues
- Going concern
Each of these general characteristics is further explained below.
There can be a massive number of inventory purchases, conversion, sales and returns during a client’s reporting period. The cost profile of each inventory is unlikely to be similar, so the auditor cannot rely on testing just a few high-cost transactions. Instead, it will be necessary to conduct more randomized testing across the population of inventory transactions.
Inventory may be stored in multiple locations, where each location is subject to differing levels of security and has different levels of record accuracy. For example, the main warehouse storage facility might be tightly controlled, while other locations have significantly lower levels of controls. When significant amounts of inventory are located in low-control areas, the risk of a material misstatement is increased.
Proportion of assets
In some industries, such as retailing and warehousing, inventory comprises the bulk of all assets. In these cases, the auditor must be assured of the correct inventory valuation, or else there is a heightened risk of material misstatement.
Diversity of items
It can be difficult for an auditor to be sufficiently familiar with inventory items to verify that a client is reliably assigning the correct values to them. For example, an auditor may deal with a broad range of inventory items, including jewellery, commodities, liquids, animal products, and so forth.
There are 2 costing methods available under the Singapore Financial Reporting Standards (International), which are FIFO or weighted average. Each of them can result in somewhat different inventory costs. It is possible that a client may even use a different costing method for each class of inventory. The range of possibilities introduces additional complexity to the auditing task.
There is a significant fraud risk associated with inventory for multiple reasons. If the goods can be easily resold, then there is a heightened risk of theft. Also, incorrect inventory counts and valuations are a common tool of managers who want to falsify the reported financial results of a business. Simply inflating the reported inventory figures at year-end artificially reduces the cost of goods sold, thereby increasing profits in the income statement.
Impact of cutoff issues
If inventory is incorrectly added to or withheld from the year-end physical inventory count, this has a direct and potentially quite significant impact on the reported profit of the client.
Depending on the nature of the inventory, it can begin to lose value relatively quickly. When inventory is perishable, it can become obsolete in as little as a few days. In other cases, the rate of obsolescence is much longer. Items may still be sellable several years after they have been produced. Thus, depending on the circumstances, there can be a significant risk that a portion of the inventory can no longer be sold at all, or nowhere near its intended selling price.
In some industries, it is necessary for entities to maintain relatively high inventory balances in order to sell effectively. This can mean that a large part of the total investment in a business is tied up in the inventory asset. If a significant proportion of the inventory is obsolete or slow-selling, the business may not be able to liquidate the inventory quickly enough to pay its bills in a timely manner. If so, there can be an issue with whether the client is still a going concern.
These characteristics indicate that a large proportion of the total audit budget may need to be concentrated on inventory, depending on the type of business. Also, when there is a heightened risk of financial statement fraud, the auditor must be unusually vigilant in auditing inventory, since there are many opportunities for the misstatement of the asset. In short, the auditing effort expended on inventory may be substantial.